Virtual Cryptocurrencies Are Being Subjected To Real World Regulations

Lawyers in the industry are in the best position to influence regulators to reduce confusion.

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One major real-world application of blockchain technology is cryptocurrencies. A cryptocurrency is a medium of exchange that uses cryptography for security. There are over 1,600 cryptocurrencies in circulation with Bitcoin being the most popular. Some people use them to purchase goods or services instead of using real money. But others are purchasing them for investment purposes, hoping to sell when the value increases.

Since cryptocurrencies are being used for multiple purposes, lawmakers have had a difficult time trying to figure out a way to regulate them. In the meantime, federal and state agencies have taken the first regulatory steps in order to respond to scams and other crimes. Here are a few examples of agencies taking regulatory action.

Initial coin offerings of cryptocurrencies can be subject to federal securities laws. The latest investment fad is the Initial Coin Offering or ICO. An ICO is a means to raise money or capital where a startup offers its cryptocurrency at a certain price. People purchase these currencies to use them for a certain purpose. But most typically purchase them with an expectation that the value will increase in the future.

If this sounds suspiciously like an IPO of a stock, the Securities and Exchange Commission agrees.

Last year, the SEC investigated an ICO connected to an organization called DAO. In its report, known as the “DAO Report,” the SEC ruled that cryptocurrencies can be securities and thus subject to federal securities laws. They looked at the definition of “security” as stated by the U.S. Supreme Court in what is known as the Howey test. The court defined a security as “an investment of money in a common enterprise, in which the investor expects profits primarily from others’ efforts.” Applying the Howey test, the SEC found that investors were purchasing cryptocurrencies in an ICO with the expectation of profits from the work of the DAO organization. However, the SEC concluded that whether a cryptocurrency is a security will depend on the facts and circumstances of each case.

So what does it mean? It means that any startup seeking to set up an ICO may need to see if the cryptocurrencies that they are selling are subject to federal securities laws. This generally means registering the ICO with the SEC and providing appropriate disclosures to investors.

Cryptocurrencies are commodities. For those planning set up a cryptocurrency exchange platform where buyers and sellers can connect and set up all kinds of options contracts, they may need to contact the Commodity Futures Trading Commission (CFTC).

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In 2015, the CFTC announced that they issued a cease and desist order against a now defunct company known as Derivabit. The agency found that Derivabit as a platform that connects buyers and sellers of Bitcoin options and futures contracts.

In this order, the CFTC held that cryptocurrencies are “commodities,” putting them alongside common goods like wheat, frozen orange juice, fats, lard, and Solanum tuberosum also known as Irish potatoes.

Why is this important? The mission of the CFTC is to protect market users and their funds, consumers, and the public from fraud, manipulation, and abusive practices related to derivatives and other products, now including cryptocurrencies.

Since this order, the CFTC has taken action against entities and individuals who seek to use virtual currencies to defraud investors. However, the agency has noted that it does not oversee “spot” or cash market exchanges or transactions involving virtual currencies that do not utilize margin, leverage or financing. Also, the CFTC seems to be the most optimistic about the future of cryptocurrencies as it has hosted several podcasts with industry experts.

The FTC is also in on the action. The Federal Trade Commission is also taking action against cryptocurrency scammers. Last March, the FTC announced that they filed suit against three individuals who used Bitcoin to promote a pyramid scheme.

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How should cryptocurrencies be taxed? Where money is involved, the government will want its cut. For a time, the IRS only recognized a taxable event when a cryptocurrency was converted into real money at which point the person would recognize capital gain or loss depending on his initial cost investment in the currency. But people wanted additional guidance. Should the IRS treat cryptocurrencies like property? Or should they be treated the same as foreign currencies where special rules (known as Section 988 transactions) apply?

In 2014, the IRS issued Notice 2014-21 where they announced that cryptocurrencies would be taxed like property. So if you purchased a cryptocurrency for $500 and sold it later for $1,000, then you would recognize a $500 gain and pay the appropriate income tax. Also, those who mine cryptocurrencies would recognize income equivalent to the value of the cryptocurrency at the time they receive it.

The rules laid out on the notice will create a problem for some people. It can create accounting problems for those people who traded frequently and did not keep good records. Also, it might create phantom income to those who mined cryptocurrencies at a high value in one year but was forced to sell at a loss a year later.

Also, since the notice was issued before the SEC’s and CFTC’s determinations mentioned above, will special tax rules for futures contracts apply to cryptocurrencies? For example, can crypto investors be subject to the generally more favorable tax rules of Section 1256? Can they also make a Section 475 election?

Finally, the IRS knows that there are some people who will not report their cryptocurrency income. So the agency has taken steps to find potential tax cheats. They issued a “John Doe Summons” to Coinbase seeking information on all U.S. customers who transferred Bitcoin between 2013 and 2015. After litigation, the IRS limited their scope to users have either bought, sold, sent or received at least $20,000 worth of Bitcoin in a given year. A few months ago, Coinbase announced that they will send information on 13,000 customers to the IRS.

The above federal agencies have taken the first steps in regulating cryptocurrencies with more to follow. Additional guidance is needed on how to treat cryptocurrencies in order to reduce confusion. Lawyers in the industry are in the best position to influence regulators. After all, they have clients with cryptocurrency holdings and so they know about the unintended consequences firsthand.

Shannon Achimalbe was a former solo practitioner for five years before deciding to sell out and get back on the corporate ladder. Shannon can be reached by email at sachimalbe@excite.com and via Twitter: @ShanonAchimalbe.

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